THE BLOG
05/21/2013 05:22 pm ET Updated Jul 21, 2013

Money Fuels Stocks

The economic news is mixed, and corporate profits are so-so. Housing is mixed, and so are reports of consumer spending. Overall the economy is growing at only about 2.5 percent, better than the negligible growth in the fourth quarter last year -- but at only about half the growth we've seen coming out of previous recessions.

So why is the stock market soaring to new highs on a regular basis?

We've all been taught that stock prices reflect the profits companies earn. Shareholders -- buyers of stock -- want to own a piece of businesses that are growing. Those businesses will either expand as they make more money, and generate more profits, leading to higher stock prices -- or pay out some of those profits in dividends. Or they could offer a combination of both types of rewards for shareholders. That's what makes stocks attractive -- future growth.

But the Dow Jones Industrial Average is has gained 145 percent from its low in March, 2009 to the current level of well above 15,000. And profits, while growing, certainly can't account for all those gains. Especially since a great portion of those profits have come from cost cutting. Everything from jobs to product sizes has been trimmed to generate more profit. (Ever notice the shrinking width of a roll of toilet paper?)

So once again, why is the stock market making new highs?

The answer is simple: MONEY is the fuel for the stock market fire. And with the Fed creating an additional $85 billion in new credit every month, all that money has to go somewhere. While some is sitting on the sidelines (or offshore in corporate accounts), much of it is flowing into the stock market.

Here's a look at the magnitude of the increase in the monetary base -- the latest figures from the Federal Reserve Bank of St. Louis, which tracks the numbers.

Just as water seeks its own level, money floats stock prices higher. Investors have few competitive choices. They keep their money in dollars, because of worries about the future value of the Euro and the Japanese Yen. But, once in dollars, where can the smart money stash its cash?

The Fed has aggressively kept interest rates and historic low levels. Whether that can continue is a matter of much debate, but for the moment money in the bank earns less than a quarter of one percent.

On the other hand, the dividend yield of the S&P 500 stock index is nearly 2 percent. Plus, you get potential upside (or maybe some downside) return of the stock market. Over the past 50 years, dividends have contributed nearly 40 percent of the total return of the S&P 500 stock index.

And that's why the "smart money" moved into the stock market two years ago. Sure, the first few years of gains from the 2009 bottom were a volatile rebound. But in the past year, the stock market has pushed relentlessly into higher territory, fueled by an increasing supply of money that comes not only from our Federal Reserve Bank, but from other central banks desperately trying to jump start their economies.

Money creation hasn't done so much for economic growth. But it has done wonders for stock prices!

There are other factors that move markets in the short run, causing down days for the market and individual stocks. Earnings for a company may disappoint analysts, triggering a sell-off. Political in-fighting can cause volatility. Fear of tax legislation or the implementation of new laws like Obamacare gives the market pause.

But as long as the Fed continues to create more credit than the economy is willing to use, that extra cash will flow into the stock market, pushing prices higher. Only when the Fed threatens to stop its monetary ease, will the stock market will face serious headwinds.

That's The Savage Truth.